More than 400 special purpose acquisition companies (SPACs) are scouring the private company universe for merger targets. And a few hundred more SPACs have announced merger transactions with target companies but have yet to close.

For CFOs at companies looking to go public via this abbreviated route, whether they’re considering offers from sponsors or negotiating a sponsor deal, it’s a hazardous time.

Many factors have slowed down the market for SPACs — new disclosure and accounting guidance from the Securities and Exchange Commission, too much SPAC money in trust accounts that needs to find merger targets, and the coming-to-light of some of the downsides of SPAC transactions.

But what it all boils down to for the issuer is that the SPAC process is a more precarious way to go public than is commonly touted. That’s somewhat ironic: one of a SPAC deal’s key benefits is supposed to be that it offers greater deal certainty than a traditional IPO does.

What could be a worse outcome for an IPO than having it generate insufficient equity capital to fund growth and having the stock price sink once the shares begin trading?

What could be a worse outcome for an IPO than having it generate insufficient equity capital to fund growth and having the stock price sink once the shares begin trading? Unfortunately, that’s what’s happening in some SPAC deals.

As MBP Co-Chairman Drew Bernstein pointed out in a blog post, in recent months, more investors in SPACs are pulling out their cash once the merger target has been announced (as is their right). Redemptions have averaged 50% or more in recent months (52.4% in the third quarter, according to Dealogic and The Financial Times).

A disappointing SPAC deal

One recent example involved The Metals Company, a firm founded to mine the floor of the Pacific Ocean. It merged with Sustainable Opportunities Acquisition. Not only did an overwhelming number of SPAC investors (90%, according to Bloomberg) redeem their shares, but the deal’s private investment in public equity (PIPE) funding fell through. Having hoped to raise $500 million, the company raised only $110 million. Yet, it needs billions for large-scale commercial production.

The PIPE pullout “was particularly disturbing since PIPE investors are supposed to ‘backstop’ the newly public company’s capital needs as an ironclad commitment,” wrote Bernstein.

Bernstein calls these kinds of shortfalls “ticklish” because “most SPACs have already disclosed projected milestone events and financial results contingent on raising a certain amount of capital and [those results] are ‘baked in’ to the proposed valuation.“

In the aftermarket, The Metals Company is getting burned: its shares were trading at $4.35 on September 30.

Costs and Dilution

As with The Metals Company, when the target company begins trading, things can go downhill quickly. That can even happen if the transaction meets its capital-raising goal.

The problem is inherent to the SPAC deal structure. The investors that purchase the shares of the SPAC IPO are entirely different from those that end up owning the stock in the newly public company, says Bernstein. And that second group of investors often gets the short end of the deal — the initial short-term investors (traditionally hedge and arbitrage funds) can cash out but still get warrants in the stock, and the sponsor receives “promote stock” — nearly free shares of up to 25% of those sold in the vehicle’s IPO.

As Louis Lehot of L2 Counsel, a Silicon Valley M&A and securities lawyer, told CFO in December 2020: “In a SPAC, there is always a ton of supply of common stock on the market for sale that depresses the stock price.” Who bears the cost? Retail and institutional investors seeking to hold the stock for more than just a quick flip.

Gary Gensler

Said SEC Chair Gary Gensler in a September 27 speech: “There are lots of costs that [the SPAC] structure is bearing — whether sponsor fees, dilution from the PIPE investors, and fees for investment banks or financial advisers. These costs are borne by companies trying to access markets and by regular investors.”

The dilution and costs do have long-term consequences. Renaissance Capital, a provider of IPO exchange-traded funds, found that of the 313 SPACs IPOs from 2015 to the end of 2020 that completed a merger (93 of them), the common shares had delivered an average loss of -9.6% and a median return of -29.1%, compared with the average aftermarket return of 47.1% for traditional IPOs.

At this point in the SPAC boom, there probably are too many SPACs chasing too few viable targets. “The sheer volume of funded SPACs may lead to a shortage of viable targets of sufficient scale to absorb the capital these SPAC teams have raised or cause SPACs to overpay for the limited number of viable targets,” warned CFO columnist Crocker Coulson way back in June.

As Gensler noted in a recent interview, the structure incentivizes SPACs to find a merger deal “even if it’s not a particularly great merger,” as the clock to secure one runs only two years.

If You Have To …

What can issuers dead-set on executing a SPAC merger do?

Drew Bernstein

One of Bernstein’s recommendations is common sense but rarely followed: “Successful SPAC merger candidates should have demonstrated they can commercialize their products and have sufficient customers to support a credible ramp in sales.”

Beyond that, he says, “SPAC deals need to take full advantage of the ability to refine their story and engage in price discovery in advance of making a public announcement.”

On the tactical side, to ensure that investor redemptions don’t obliterate the capital-raising objective, an issuer could take a page out of the playbook of KORE Wireless. The company and its SPAC partner, Cerberus Telecom Acquisition, set up a  redemption backstop convertible bond to offset any possible redemptions from the SPAC’s trust account. The backstop lets KORE borrow up to $120 million that the company may tap to help satisfy “the minimum cash condition at the closing of the merger with CTAC,” KORE stated in a press release.

Even with such a backstop vehicle, however, dilution may be unavoidable. Upon the KORE merger’s close, lender Fortress Credit can convert the seven-year notes into shares of KORE’s common stock at $12.50 per share. The KORE deal closed on Friday; the shares were trading at $7.13 at 2 p.m.

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